What Is the Debt/EBITDA Ratio?
Debt/EBITDA is a ratio measuring the amount of income generated and available to pay down debt before covering interest, taxes, depreciation and amortization expenses. Debt/EBITDA measures a company's ability to pay off its incurred debt, and a higher ratio result could indicate a company with a too-heavy debt load.
Banks often include a certain debt/EBITDA target in the covenants for business loans, and a company must maintain this agreed-upon level or else risk having the entire loan become due immediately. This metric is commonly used by credit rating agencies to assess a company's probability of defaulting on issued debt, and firms with a high Debt/EBITDA ratio may not be able to service their debt in an appropriate manner, leading to a lowered credit rating.
The Formula for the Debt/EBITDA Ratio Is
- Debt = long-term debt + current portion of long-term debt
What Does the Debt/EBITDA Ratio Tell You?
The debt/EBITDA ratio compares a company's total obligations, including debt and other liabilities, to the actual cash the company brings in and reveals how capable the firm is of paying its debt and other liabilities.
When lenders and analysts look at a company's debt/EBITDA ratio, they want to know how well the firm can cover its debts. EBITDA represents a company's earnings or income, and it's an acronym for earnings before interest, taxes, depreciation, and amortization. It's calculated by adding back interest, taxes, depreciation and amortization expenses to net income.
Analysts often look at EBITDA as a more accurate measure of earnings from the firm's operations, rather than net income. Some analysts see interest, taxes, depreciation, and amortization as an impediment of real cash flows. In other words, they see EBITDA as a cleaner representation of the real cash flows available to pay off debt.
- The debt/EBITDA ratio is used by lenders, valuation analysts and investors to gauge a company's liquidity position and financial health.
- The ratio shows how much actual cash flow the company has available to cover its debt and other liabilities.
- A debt/EBITDA ratio that declines over time indicates a company that is paying down debt or increasing its earnings or both.
Example of Debt/EBITDA and Interpretation
As an example, if company A has $100 million in debt and $10 million in EBITDA, the debt/EBITDA ratio is 10. If company A pays off 50% of that debt in the next five years, while increasing EBITDA to $25 million, the debt to EBITDA ratio falls to two.
A declining debt/EBITDA ratio is better than an increasing one because it implies the company is paying off its debt and/or growing earnings. Likewise, an increasing debt/EBITDA ratio means the company is increasing debt more than earnings.
Some industries are more capital intensive than others, so a company's debt/EBITDA ratio should only be compared to the same ratio for other companies in the same industry. In some industries, a debt/EBITDA of 10 could be completely normal, while in other industries a ratio of 3 to 4 is more appropriate.
Limitations of the Debt/EBITDA Ratio
Analysts like the debt/EBITDA ratio because it is easy to calculate. Debt can be found on the balance sheet and EBITDA can be calculated from the income statement. The issue, however, is that it may not provide the most accurate measure of earnings. More than earnings, analysts want to gauge the amount of actual cash available for debt repayment.
Depreciation and amortization are non-cash expenses that do not really impact cash flows, but interest on debt can be a significant expense for some companies. Banks and investors looking at the current debt/EBITDA ratio to gain insight on how well the company can pay for its debt may want to consider the impact of interest on debt-repayment ability, even if that debt will be included in a new issuance. For this reason, net income minus capital expenditures, plus depreciation and amortization may be the better measure of cash available for debt repayment.